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Financial Reporting & Analysis
Day 9
Dawn Matsumoto
December 1, 2012
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Administrative Details
Next (and Last) Class• Project presentations!
Final Exam• Available after class on Dec 7th, due Monday Dec
10th by midnight• Practice Final posted on BB• Brady will go over in help session this week
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Today’s Agenda
Harnischfeger • Earnings quality
Wrap-up
But first…
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Accounting in the News
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Three reactions…
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Now, on to the case…
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Quick History
• 1884: Alonzo Pawling and Henry Harnischfeger opened a machine shop in Milwaukee
• P&H cranes
• Experienced considerable success...
Henry’s home built in 1905
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Quick History• 1931: son Walter Harnischfeger
becomes president; retires as Chairman of the Board in 1970
• 1959: grandson Henry Harnischfeger becomes president and guides Harnischfeger Corporation through significant growth in the 1960s & 70s
• 1971: listed on NYSE• 1970s: explosive growth largely
financed with debt
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• Early 1980’s: worldwide recession reduced demand for Company products
• 1982: net loss of $77 million and...• Defaulted on debt covenants:
• Unconsolidated Finance subsidiary also defaulted on debt covenant
• “Qualified” audit opinion
Case setting: 1980s
>>>
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1982 Recovery plan
• Hired new COO William Goessel. (Grandson Henry Harnischfeger steps aside.) In 1983, hired new CFO (Jeffrey Grade)
• Cost reductions to lower break-even point• Reorient business strategy • Renegotiated debt with bankers• Net loss narrowed to $35 million in 1983.
“Return to profitability soon”
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Management StatementEarly 1984
“We approach our second century with optimism, knowing that the negative events of the last three years are behind us, and with a firm belief that positive achievements will be recorded in 1984. By the time the corporation celebrates its 100th birthday on December 1, we are confident it will be operating profitably and attaining new levels of market strength and leadership.”
two “promises”?
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1984 “centennial” year results• Reported profits in each of the 4 quarters • Sales up 24% (mining equipment up over
60%)• Raised new equity capital to pay off
restructured debt• Increase in unshipped Backlog and Bookings
of new orders• Early 1985: Analyst issued buy
recommendation
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Leading Wall Street Investment House
(just before release of 1984 Annual Report)“We recommend the stock of Harnischfeger Corporation for purchase in speculative accounts because we expect the company to report a modest profit this year and untaxed earning of $3 per share in 1985, following ten years of deteriorating financial statements and two years of large losses. Earning power, assuming a sustained recovery of the company’s markets, could be $4 to $6 per share in the 1986-87 time period. Harnischfeger stock is selling at less than three times these peak earnings (were they taxed) and at a slight discount to book value.”
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Would you potentially have been interested in investing in
Harnischfeger?
Trying to avoid hindsight & before taking this course...
VOTE?
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Would you now?
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How did they achieve profitability?
Q1: Identify areas of concern...
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Historical Interest Rates
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Q2a. Why did management make these changes?
Q2b. Will analysts, investors & others “see through” these
changes?
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Harnischfeger Management speaks...
“In accounting there is no such thing as an absolute truth. The same underlying reality can be accounted for using a range of assumptions. The earlier philosophy of this company was to choose the conservative alternative whenever there was a choice. Now we have decided to change this. We would like to tell the world we are still alive and well.”
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More Management Quotes
“When the outside world compares our financial performance with that of other companies, they may or may not take the time and effort to untangle the effects of the differences in financial policies that various companies follow.”“But suppose (users) do not adjust. Then clearly we are better off following the more liberal policies rather than conservative policies.”
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Last Management Quote
“As a company you have to put your best foot forward if you want to raise capital, convince customers that you are a viable company, and attract talented people to work for the company. I feel that financial reporting should help rather than hinder the implementation of our operating strategy.”
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Harnischfeger Subsequent Events1987:
• Received takeover offer from Columbia Ventures, Inc. for $19 per share in cash. Considered inadequate and rejected.
1990:• Jeffrey Grade took over as Chairman & CEO• “Dashing & flamboyant leader” • More acquisitions & debt
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Harnischfeger Stock prices: 1988-2001
• 1999:• Jeffrey Grade resigned• Delisted from NYSE• Filed for Chapter 11
failed to meet expectationsin 14 of 24 quarters as CEO
$10
$50
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July 2001: Emerged from bankruptcy as Joy Global...
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Joy Global stock prices: 2003-2011
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Takeaways
Accounting numbers are widely used by external parties. Managers want to influence the perceptions and behaviors of these company stakeholders.
U.S. GAAP allows managers latitude in accounting choices (e.g., selection of methods and estimates, timing of recognition, classification on financial statements).
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Takeaways Management may choose its accounting
policies: • as a reflection of the company’s overall strategy, • as an attempt to influence analysts,• as an attempt to influence other stakeholders
(including employees, customers and suppliers),• as an attempt to provide more useful information
to users of financial statements, and/or• as an attempt to increase their personal wealth
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Takeaways
Understanding management’s motives is important in assessing the firm’s current performance and future potential.
Lots of attention is appropriately focused on the motives and actions of management, the board & the external auditor.
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Takeaways
Adjusting for differences in financial reporting policies can be crucial in evaluating a company’s performance and/or financial position relative to its competitors. Since we are ultimately interested in understanding the firm’s underlying economics, we should ask:• What are the firm’s “core” continuing earnings?• What reported items are one-time effects? • What reported items have no cash flow effect? • How “cosmetic” differences affect stakeholder behavior?
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Our Goal... To uncover the underlying economics, we have repeatedly
taken an analyst perspective and adjusted for differences in financial reporting policies, e.g., • Alaska Gold’s success in mining operations• Exxon Mobil’s use of LIFO (inventory, CGS, earnings & tax effects)• Circuit City’s partial recognition versus full deferral of extended
warranty contracts• Microsoft’s research & development costs• Starbuck’s off-balance sheet financing via long-term leases• Groupon’s gross method for revenue; adding back mktg costs• Harnischfeger (in many areas)
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As we approach the end of the course, how much have you learned
since early September?
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HP Recent Performance
Q12011 Q22011 Q3 2011 Q4 2011 Q12012 Q22012 Q32012 Q42012
-10000
-8000
-6000
-4000
-2000
0
2000
4000
6000
Op IncOp Inc -- Adj
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Autonomy Pre-merger Performance
2007 2008 2009 20100
100
200
300
400
500
600
700
800
900
1000
RevenuesGross ProfitOperating Income
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“Top Ten” Takeaways from Financial
Reporting
Dawn MatsumotoExecutive MBA program
Regional 30December 1, 2012
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Financial reporting is an art, not a science
Users & analysts should NOT take financial reporting as the
“TRUTH”
11…
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10. Reliable Financial Information is crucial for a well functioning global
market economy
Entrepreneurs
Capital Providers
Information
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Fmr SEC Chairman Levitt
“If a company fails to provide meaningful disclosure to investors about where it has been, where it is, and where is going, a damaging pattern ensues. The bond between shareholders and the company is shaken; investors grow anxious; prices fluctuate for no discernable reasons; and the trust that is the bedrock of our capital markets is severely tested.”
1998 speech
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9. Financial Statements provide a view into the
economics of the organization (not the view)
(Largely) A rear view mirror
View keeps changing
Size and quality of view varies from:
>LARGE & CLEAR
>small & obstructed
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Seymour Cray Story
Founder Seymour Cray voluntarily decides to leave Cray Computing
On that day, the stock price of Cray drops dramatically
On that day, the Company’s accounting system records...
In the next fiscal qtr, the accounting system records...
Nothing
less compensation expense (because...) and thus higher earnings
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8. How Accounting WorksBeg of Period
ASSETS = LIAB + EQUITY
Contributed Capital
Retained Earnings
End of Period
Contributed Capital
Retained Earnings
R/E
Income Statemen
t
Balance Sheet
Balance Sheet
NI - DIV
ASSETS = LIAB + EQUITY
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7. Tax Reporting ≠ Financial Reporting!
Tax Return Income Stmt
Income ≠ Revenue
- Deductions ≠ - Expenses
Taxable Income ≠ NI b4 tax
Tax owed ≠ Tax expense
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6. Earnings ≠ Cash flows
I/S (accrual) ≠ CF Stmt (cash)
Revenue ≠ Cash collected from customers
Expenses ≠ Cash expenditures
NI ≠ Cash from operations
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5. Consider the time value of
money!
“Compounding is mankind’s greatest
invention...”
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4. Managers face HUGE pressure to meet/beat Wall
Street targets
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3. You get what you measure!
Setting targets (benchmarks, budgets can:
Align employee and company (shareholder) goals
Motivate employees to perform
Lead to genuine positive economic performance
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3. (cont’d) OR you might get...
pressure to make the numbers (anyway that you can)
pressure to guide analysts to lower their forecasts
pressure to time economic decisions even if not in the long run interest of the company
pressure to play accounting games
the DARK side...
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2. More than ever, everyone is watching...SEC
Congress
Press
External auditor
PCAOB
Board of directors
Internal auditor
Management (hopefully)
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and takeaway #1 is...
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#1 Beware of the
earnings game!
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So, what do managers ‘dream’ about?
Blockbuster new products?
Mega-mergers?
Dominating the Internet?
Global domination?
Galactic domination?
Making quarterly earnings!?
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The Big Problem?“Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers -- CEOS you would be happy to have as spouses for your children... -- have come to the view that it’s okay to manipulate earnings to satisfy what they believe are Wall Street desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.”
Warren BuffettJuly/Aug 1999Directorship
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Objectives of the Earnings Game
Smooth (non-volatile) earnings
Avoid losses
Avoid decreases in earnings
Beat the consensus analyst forecast of earnings
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Evidence of Earnings Management (EM)?
Research by Prof. Dave Burgstahler
your managerial accounting instructor
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Meet or Beat?Target #1 = to be profitable (i.e., avoid losses)
So what is odd in this figure?
Loss Profits
too few
too many
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Meet or Beat?Target #2 = to improve profits
So what is odd in this figure?
Lower Profits Higher Profits
too few
too many
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Takeaway from Dave’s Research?
In a large sample, we see direct evidence of earnings management (EM) to beat targets:
1. Reporting positive profits2. Improving profits3. Meeting/Beating analysts’ forecasts
i.e., EM is more common than the occasional anecdote one reads about in the press
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And now for our final “course summary”...
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IT’S JEOPARDY!the rules of the game are...
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• Scorekeeper is Brady.
• Rotate by study group starting with the RED team .
• Select category and point amount up to 300 in round #1, 400 in round #2, 500 in round #3.
• You must respond in the form of a question, e.g., to the answer “State capital of Washington.” you would respond: “What is Olympia?”
• Your group has 15 seconds to respond. (The class may sing along: Do, do, do doo…)
• If your question is incorrect, next team in line can answer (and then the next team, and the next team…). Whichever team answers correctly, gets the points.
• Regardless of who answers the question, we return to the original order.
• The top two teams will compete in the “Final Jeopardy” round starting with zero points.
• Dawn will resolve any disputes.
• The team with the highest point total wins! (but don’t get too excited)
Official EMBA 505 Jeopardy Rules
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to the game...
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Next week:Project
Presentations
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What I hear, I forget
What I see, I remember
What I do, I know
When I do Accounting, I marvel, and I learn to be a better person
for awhile
Chinese proverb (roughly translated with liberties taken)